9/11/2014

Unexpected growth in consumer spending and residential construction have seen the Canadian economy outperform in 2014, but continued low interest rates and a cheaper loonie are necessary to sustain growth going forward, finds a new report from CIBC World Markets.

The report notes that while Canada's economy will see better than three per cent growth in both the second and third quarters, the drivers are not sustainable. "Neither housing nor consumption funded from a falling savings rate can be the permanent drivers of growth, so all eyes will be on capital spending and exports," says Avery Shenfeld, Chief Economist at CIBC. "The market's response will be less about getting two and a half per cent growth to close the output gap, than about the policy backdrop needed to do so."

Mr. Shenfeld expects the U.S. economy to continue to improve and Canada's to track along with it but with the countries taking a differing approach to monetary policy. "We're not at zero, so there's less urgency to begin dialing down the stimulus. But more critically, Bank of Canada Governor, Stephen Poloz wants growth led by exports and capital spending. There's no specific FX target, but a weaker Canadian dollar will be a key ingredient in restoring competitiveness and making Canada an attractive place to expand capacity."

He says this will be achieved by letting the U.S. eliminate the entire Canada-U.S. short-rate differential before we see even one Bank of Canada hike. A much weaker loonie could then allow the Bank to carry on to a 1.5 per cent overnight rate by year end 2015.

Co-authors, Benjamin Tal and Nick Exarhos write that an improving economy stateside has already started to help Canadian exports. "Geography always makes the U.S. key to Canada, but America's outperformace vs. other G-7 countries is enhancing that dependence. In fact, exports destined to the U.S. market are already growing at a near 17 per cent year-on-year pace, while those destined elsewhere up by just under 11 per cent."

However, much of the current momentum is coming from energy exports, now delivering a quarter of Canada's dollar value of outbound shipments. Estimates from the Canadian Association of Petroleum Producers suggest that black gold's shine isn't likely to fade any time soon. Applying production estimates to their relatively stable historical relationship to exports destined for the U.S., suggests that Canada in 2016 will have exported more than 230 million additional barrels than it did in 2013.

But energy's growing share also reflects what was, until very recently, a lacklustre performance by other exporters. The Bank of Canada identified sectors like forestry products, machinery, aircraft products, and other electronics as key in carrying the next leg of Canadian export resurgence, but this group has actually trailed other non-energy exporters in the past year.

A key factor in this is that many non-energy exports historically came from sectors sensitive to the exchange rate. The long period in which the Canadian dollar was overvalued led to exits of plants from this country, taking out the capacity that would now typically be responding to better news stateside.

With the weaker value of the Canadian dollar providing a more competitive exchange rate and positive price shocks for some products such as food, the loonie-sensitive sectors have seen an 11.8 per cent gain in nominal exports in the past twelve months, vs. 8.7 per cent for other non-energy industries.

"But there is much more to do ahead," says Mr. Tal. "There are lags before the full impact of the late 2013 depreciation will be fully felt by existing plants. And we will likely need even more time, and a still weaker exchange rate, to prompt the entry of new production facilities that can start to fill the void left by earlier exits.

"Thus far, after the steepest correction in the post-war period, and an initially strong rebound, capital spending is well below where it typically should be at this more mature stage of the cycle. And the issue is not capability. Our business capability index, which uses an array of indicators to measure the ability of Canadian firms to spend, is close to a record high. That suggests that financial limitations aren't the culprit. It's all about the willingness to invest."

He notes that Corporate Canada appears more inclined to spend on bricks and mortar or takeovers elsewhere. "Foreign direct investment (FDI) by Canadian companies rose by a record high nine per cent in 2013—the exact opposite of the decelerating growth trajectory in capital spending at home. The ratio of the outflow of FDI to capital expenditure is close to 20 per cent—again a record high."

But he says that at some point businesses have to invest in existing facilities at home. Right now a growing proportion of each capital spending dollar is devoted to replacement investments that simply maintain existing levels of production. The practical implication is that capital investment must rise much more quickly in order to accommodate both replacement and expansion investments.

There are signs that, despite some reservations, spending is about to accelerate. Mr. Tal says the Bank of Canada's Business Index is now at a level that, in the past, was consistent with real business investment climbing by close to five per cent on an annual basis.

Mr. Shenfeld says that with the backdrop, corporate earnings still have room to run. "Our top-down model, which ties key economic indicators - such as Canadian and U.S. GDP and various resource prices - to bottom line results, projects TSX Composite earnings growth of 11 per cent in 2015. That's above the historical average. Bond yields will provide some noisy volatility for stocks, but double digit earnings gains should still see major indexes close next year at moderately higher levels."